Gold, Silver, Metal Prices: Commentary – 11/6/2009

Class Is Now In Session

Good Day,

Speculation early this morning was that U.S. employers likely have cut only 150,000 jobs in the month of October, a figure which would be the lowest in more than a year. The worst labor-market slump since the 1930s is now seen as possibly bottoming out, and the possibility of future consumer spending is now seen as adding to US and global economic growth.

The actual numbers, however showed a bit of a different reality, as the U.S. economy shed 190,000 jobs last month, lifting the unemployment rate above the 10% mark (to 10.2%) for the first time in 26 years, the Labor Department said. Economists were looking for the unemployment rate to rise to 9.9%

Following yesterday’s brief pause and minuscule retracement, gold prices remained within striking distance of the $1100 level early this morning, as speculative interest was banking on Friday’s US jobs report to yield further fuel for what has now become a routine spec fund-driven play. That is, when/if economic news is good, the dollar sinks and risk appetite reignites on the perception that such good news will drive the Fed to keep handing out essentially free money with which to go out and buy… stuff.

Does not matter what the ‘stuff’ is. So long as the money to buy it with, can be had/borrowed for close to nothing. What would you do, if the ushers at the MGM Grand in Vegas handed you a wad of $100 bills upon entering the casino? However, as it was once sadly learned a long time ago at the same facility, not everyone can successfully run for the ‘fire exit’ doors at once.

Our friends at GoldEssential.com, over in Belgium, got an early start on describing what is and what might be unfolding in Friday’s market, and it went something like this:

"Gold ticked up on Friday in early London dealings, after minimal consolidation the previous day, as the EUR/USD pair kept strong ahead of the U.S. Payrolls data later today and as the yellow metal continued to be supported by rumors of further central bank reserve diversification into gold, said Carl Johansson, Sr Precious Metals analyst at Goldessential.com

A Financial Times report stating that the Sri Lankan central bank had been buying gold to diversify its currency reserves following unwanted volatility in the FX market was seen supporting gold, Johansson said. "While the absolute level of these purchases was rather limited at an estimated 5 tonnes, it again confirmed some of the rumors that have been driving gold higher earlier in the week following India’s 200 tons gold purchase from the IMF", Johansson added.

"Gold still has the opportunity to take a shot at the $1,100 an ounce mark, possibly later today", said Evelyne Winters at Goldessential. Equity markets and the EUR/USD pair were chalking up losses earlier in the week, but have witnessed reversal that was inspired by the rally in gold, a more upbeat FOMC statement and better than expected non-farm productivity. The feeling is that these markets want to go higher, with gold equally so, she added, referring to the fact that despite slight overbought conditions, little material profit taking had yet been seen in gold.

Winters however added that "it’s getting overly speculative from here." Physical demand from India is weak and ETF studies show nearly no fresh inflows, showing investors being very wary about picking gold up at these prices. The feeling that there will be top formation on the short-term has grown significantly. But then again, these speculators are aiming for at least a test of $1,100 an ounce mark, and the sentiment remains at their side, she added. "Currently, we’re expecting to see a speculative blow-off to the topside over the next week or two, followed by a correction back towards $1,000 an ounce." Ms. Winters said."

The latest roundup of metals prices showed gold that gold indeed reached the $1,100 mark (and a couple of dollars more as well) and retrenched subsequently, but was still ahead by $4.00 per ounce, trading at near the $1094.00 level in mid-morning dealings in New York. Overnight ranges were fairly tight, with the metal bouncing inside a $1089-$1098 channel as the trade awaited the all-important US labour statistics.

Silver initially rose 12 cents to trade at $17.51 per ounce, but was last seen flat, quoted at $17.39 the ounce. Platinum was flat on the open, quoted at $1355 but subsequently lost as much as $16 per ounce (to $1339) and while palladium also advanced at the start of the day, by $1 to $330 per troy ounce, it later fell $3 to $326 per troy ounce. Rhodium gained $50 to rise to $1850.00 overnight.

It appears that Dr. Roubini’s ‘"mother-of-all-bubbles" alarm bell is being heard by more than just the crowd that was assembled over at the NYSE on Wednesday, at the Inside Commodities annual conference. Yes, such words are totally lost on someone such as Jim Rogers, but, hey look who is paying attention to the professor’s words of caution:

"U.K. Chancellor of the Exchequer Alistair Darling said the Group of 20 nations should develop a way to tackle asset-price bubbles as the world’s leading economies recover. "We have got to make sure we don’t get ourselves into a situation where some pressure starts to rise and then it becomes bigger and bigger and when the whole thing comes to an end it has catastrophic consequences," Darling said in an interview with Bloomberg Television.

The comments help shape the agenda for a meeting of G-20 finance ministers hosted by Darling today in St. Andrews, Scotland. They echo calls from the International Monetary Fund and Nouriel Roubini, the New York University professor who predicted the crisis that began in 2007. The Federal Reserve, the European Central Bank and the Bank of England this week moved to unwind some of the emergency steps they took to rescue the world economy from its sharpest slump since the Great Depression. Finance ministers today also will discuss a strategy to exit their fiscal stimulus measures.

Near-zero interest rates in the U.S., Britain and Japan are depressing the dollar and fueling a surge in asset values, Roubini said on Nov. 1. Commodities led by gold are trading near record highs, and cheap borrowing costs are pushing up property and equity prices. "We also have this concern," Russian Finance Minister Alexei Kudrin said in an interview in London yesterday. "We need to be very careful with this huge amount of injected liquidity."

Fueled in part by record-low interest rates, the value of stocks worldwide has more than doubled to $47 trillion from this year’s low on March 9. Oil passed $80 a barrel on Oct. 21 for the first time in a year, and gold reached an all-time high of $1,097 an ounce on Nov. 4. U.K. house prices climbed 1.2 percent last month to an average of 165,528 pounds ($270,000) after rising 1.5 percent in September.

Using monetary policy to puncture bubbles would undo a previous consensus in which central bankers largely left investors to decide when asset prices were overvalued and then acted to address the economic aftershocks of market corrections. Central banks in Australia and Norway recently noted rising property prices when raising interest rates. A survey of 147 clients by New York-based Goldman Sachs Group Inc. found 75 percent think low rates are triggering "too-strong" climbs in assets. Even as they kept interest rates on hold, the Bank of England and ECB both signaled yesterday that they may be approaching the end of their emergency stimulus policies. A day earlier, the Fed outlined the circumstances in which it would be prepared to raise rates."

If you think that the central bankers will never again raise rates, let the inflation hydra (you know, the hyper variety of same) out of the canvas bag, and effectively assist for much longer with the creation of some larger than current bubbles, we say – think again. No such entity is prepared to deal with the consequences of another burst – one that would be significantly more damaging than the one that popped recently. The mop-job that will be undertaken ( in six months? in nine months? – it is not IF, but WHEN) will be as aggressive, as frequent, and as visible as was the largesse with which the opposite happened since the fall of 2007. You can…bank on that.

As for going back to ‘the you-know-what-standard’ well, that’s not in the cards, either. National Post blogger Ian McGugan found himself on the receiving end of some rancorous e-mails from certain ultra-bullish gold quarters after trying to explain the unlikelihood of a return to Eldorado by global central banks. Why, those vitriolic missives that Ian got remind me of something that I just got yesterday!

A certain Mr. Wistar Holt (he, a key member of an organization that promulgates the theory that the old market is rigged/suppresses/manipulated/etc.) sent this writer an overtly threatening e-mail (you know, like the Sicilian message about Mr. Luca Brasi sleeping with the fishes) and advised this writer to ‘watch his back’ when next out in public. Now that this is out in the open, maybe you can all help me watch my back, and Ian’s too, and anyone else’s who dares to use his right of free speech, or that of putting forth an opinion to challenge the propaganda of the histrionic, the illogical, the uniformed, and the unhinged bullion bullies. Anyway, wrote Ian in the National Post:

"The experience of the 1920s and the 1930s demonstrates the problems with the gold standard. If you want to know how contemporary economists think of the situation, read Barry Eichengreen’s Golden Fetters or peruse Ben Bernanke’s Money, Gold and the Great Depression (available on the Federal reserve website.) Here’s an excerpt from Bernanke’s paper in which he explores the reasons behind the Great Depression:

First, the existence of the gold standard helps to explain why the world economic decline was both deep and broadly international. Under the gold standard, the need to maintain a fixed exchange rate among currencies forces countries to adopt similar monetary policies… Perhaps the most fascinating discovery arising from researchers’ broader international focus is that the extent to which a country adhered to the gold standard and the severity of its depression were closely linked. In particular, the longer that a country remained committed to gold, the deeper its depression and the later its recovery (Choudhri and Kochin, 1980; Eichengreen and Sachs, 1985)."

Professors (yes, this is academic week, folks) Nick Rowe and Stephen Gordon (of Carleton and Laval, respectively) explain the how’s and whys of central banks, reserves, and fiat money. Today’s lesson in Central Banking 101, may also explain why Canada can get away with holding less gold (3 tonnes) than the above mentioned Sri Lankan central bank (the tiny purchase of gold by which will now be hailed as a sure-fire sign of gold’s upcoming moonshot) and still not fall into a black hole in the ground that will somehow open up underneath its foundations in Ottawa:

If you look at the balance sheet of a central bank, you will see it has liabilities (mostly currency) and assets (normally mostly government bonds/bills). Why do central banks have assets? Do they need them? The wrong answer is that central banks need assets to "back" the value of the currency, and that paper currency would be worthless otherwise. The right answer is: since the government gets all the profits from a central bank anyway, there’s no point in giving the government the assets; that owning assets lets the bank reverse course and reduce the money supply if it ever needs to; and it stops the accountants freaking out.

Let’s deal with the wrong answer first. According to the "backing" theory of the value of money, the value of a central bank’s currency is equal to and determined by the value of the central bank’s assets backing the currency. (This is different from the fiscal theory of the price level, which says that the value of currency plus bonds is equal to and determined by the present value of primary fiscal surpluses.)

The backing theory sounds good. How can intrinsically worthless paper money have value? Because it is backed by valuable assets. It’s just like shares in a mutual fund, which have value equal to and determined by the value of the assets in the fund. Here are three arguments against the backing theory of money:

1. The assets of central banks are normally nearly all nominal assets, denominated in the same currency as the liabilities. Suppose the price level were to double magically overnight, and the real value of currency halved. The real value of the bonds held by the central bank would also halve. So a magical doubling of the price level would not violate the equality between the value of the currency and the value of the assets backing it. The backing theory leaves the price level indeterminate. It could only pin down the price level if the assets were real assets. If (say) 10% of the bank’s assets were real (gold reserves, plus the building), then a 1% loss of its real assets (the building burns down) would cause a 10% jump in the price level.

2. Suppose a mutual fund held bonds, but all the interest on the bonds (minus the administrative expenses of running the fund) were handed over to some third party, and not to the owners of shares in the mutual fund. Who would want to own shares in that mutual fund? The net present value of the dividends paid to the shareholders would be zero, so the shares would be worth zero too. But this is exactly what central banks do. Every year central banks earn profits from the interest on the bonds they own, minus administrative expenses, and hand the whole of that profit to the government, not to the holders of currency.

3. We don’t need "backing" to explain why money has value. People want to hold a stock of money because money is a medium of exchange, and holding a stock of the medium of exchange makes shopping easier. This creates a (stock) demand for money. Provided the central bank restricts the supply of money, the intersection of demand and supply curves creates a positive equilibrium value of money (a finite price level). Now you could argue that if paper money were worthless it could not function as a medium of exchange, so you need to assume paper money has value in order to explain the value it has, so the demand and supply theory of the value of money begs the question.

There is some truth in this criticism of standard theories of the value of money. There are indeed two equilibria: the normal one, where paper money has value, and a weird one, where it is worthless. But Ludwig von Mises, for example, addressed this problem in 1912 with his "Regression Theory of Money." Historically, money needed to be commodity money, or have commodity backing, in order to get started. But once it does get started, as a social institution, the demand for a medium of exchange supplements the industrial demand for the commodity, and the commodity backing can eventually be withdrawn as custom keeps us out of the weird equilibrium. (When Cambodia reintroduced paper money, after the fall of the Kymer Rouge, it could not create paper money ex nihilo, but initially made it convertible into rice, IIRC.)

A Ponzi scheme is a financial institution with liabilities and no assets backing those liabilities. Paper money can operate just like a Ponzi scheme, but with one important difference. Mr Ponzi promised his clients high rates of interest and/or capital gains. They would not have held his liabilities unless they believed him. The Bank of Canada promises zero interest, zero nominal capital gains, and a minus 2% real rate of interest on people who hold its paper money. Mr Ponzi could not deliver on his promise, even if he hadn’t spent the assets. The Bank of Canada can deliver on its promise, even if it gave away all its assets, provided the (real) demand for its paper money does not fall over time more quickly than 2% per year. (If the real demand for money were falling at 2% per year, a constant nominal supply of money would yield 2% annual inflation).

The Bank of Canada does not need assets, because the long run growth in the (real) demand for its paper exceeds the real interest rate at which people are willing to hold its paper. If Mr Ponzi could have met the same test, he wouldn’t have needed assets either. People are willing to hold paper money, even at very negative real rates of return (Zimbabwe), because doing so makes shopping easier. The only reason that the value of a central bank’s liabilities are roughly equal to the value of its assets is that whenever the difference between them (its net worth) gets too big, the bank hands its profits over to the government. If central banks choose to keep assets equal in value to their liabilities, and only hand over their annual profits to the government, then saying the value of their assets determines the value of their liabilities gets causality reversed. It is the value of their liabilities that determines the value of their assets.

So why do central banks hold any assets at all? Three reasons:

1. It makes no difference to the owners of the central bank (the government) whether the central bank keeps the bonds and hands the interest over to the government each year, or whether the central bank gives the bonds to the government. The government gets the interest either way; it just passes through another pair of hands. It’s a wash.

2. Normally the real demand for paper money grows at about 3% per year (roughly the same as GDP growth rate), but sometimes it rises faster than this (like last year), and sometimes it falls (like next year?). If the demand for money falls, the central bank needs to reduce the supply of money to prevent inflation, and it reduces the supply of money by selling assets. If it had given away all its assets it wouldn’t be able to do this.

3. Accountants like double-entry bookkeeping and balance sheets and stuff so they can keep track of things. They like to record assets on one side, and liabilities on the other side, to make sure that everything adds up, to check that everything’s been properly recorded. So they like to list currency as a liability of central banks (even though it isn’t, because there’s no promise to redeem it, or pay interest on it), and assets on the other side. An accountant would freak out if he recorded currency as a liability and couldn’t find an equivalent value of assets. He would say that the central bank is a Ponzi scheme. Which of course it is. And it’s just not worth the hassle of trying to explain to accountants that some Ponzi schemes are sustainable, really."

There will be no quiz. However, the above is worthwhile take-home homework for the weekend.

Speaking of weekend, we wish you a pleasant one.

Jon Nadler
Senior Analyst

Kitco Metals Inc.
North America

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